Rolling the Housing Dice, Again!

The alarm bells are now ringing for the Federal Housing Administration, with delinquencies increasing. The immediate and pressing issue is the safety and soundness of the FHA today and the risk it poses to the taxpayer.

In a paper entitled “Too Early to Sound the FHA Alarm,” the Center for American Progress (CAP) comes to the defense of the Federal Housing Administration (FHA), the troubled federal housing entity. In doing so, CAP sounds eerily similar to Representative Barney Frank’s position regarding Fannie Mae and Freddie Mac in 2003: “I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing.”

Recall that as late as July 2008, a mere two months before being placed in conservatorship, Fannie and Freddie’s regulator found them to be “adequately capitalized, holding capital well in excess of the OFHEO-directed requirement, which exceeds statutory minimums.” It was only after the Treasury Department and FHFA (successor agency to the Office of Federal Housing Enterprise Oversight) retained Morgan Stanley to probe the companies’ finances that the companies were found to be woefully under-capitalized.

The alarm bells are now ringing for the FHA, with delinquencies mounting. Traditionally, FHA had guaranteed low down payment loans to first-time home buyers and borrowers with impaired credit. The FHA was established in 1934 and for many decades its focus has been on low-income and first-time home buyers. Over the last 30 years, about 10 percent of the loans it insures have gone to claim, about 10 times the rate for prime loans. This rate is so high because FHA borrowers make extremely small down payments on loans that amortize slowly, generally have poorer credit records than prime borrowers, and many, if not most, have total debt-to-income ratios usually associated with subprime borrowers.

No private entity would be allowed to continue operating, much less grow rapidly, if it were insolvent based on its balance sheet, much less rely on ‘capital’ it expects to earn over the next 30 years.

FHA’s delinquency rate is increasing, with 17.42 percent of all FHA loans delinquent 30 days or more as of November 2011. FHA now has over $1 trillion in insured loans outstanding. While the credit characteristics of FHA’s guaranteed loans have improved somewhat when compared to three or four years ago, about three-quarters of FHA’s home purchase loans in 2010 were still high risk, having a down payment of less than 5 percent and/or a FICO credit score of less than 660, with many of these having a total debt-to-income ratio greater than 45 percent.

CAP takes issue with analyses that Professor Joe Gyourko of the Wharton School and I have published. These analyses point out many weaknesses in the actuarial review of FHA’s single-family mortgage insurance program prepared for the Department of Housing and Urban Development and relied on by CAP in its analysis. Even given the review’s overly optimistic analysis, HUD notes in its Annual Report to Congress on FHA’s financial status that “with economic net worth being very close to zero under the base-case forecast, the chance that future net losses on the current, outstanding portfolio could exceed capital resources is close to 50 percent.”

The immediate and pressing issue is the safety and soundness of the FHA today and the risk it poses to the taxpayer. No private entity would be allowed to continue operating, much less grow rapidly, if it were insolvent based on its balance sheet, much less rely on “capital” it expects to earn over the next 30 years.

Here are a dozen facts about which there is little or no dispute:

1. FHA is a rapidly growing financial guaranty agency with more than $1 trillion in outstanding guarantees, representing 7 percent of national output.

2. FHA has been out of compliance with its statutorily mandated capital ratio for more than three years.

3. FHA’s average new home buyer is leveraged 30 to 1.

4. FHA admits that many borrowers’ down payments are overstated since its current seller concession policy promotes inflated appraisal values. Appraisers may ignore the impact of concessions paid by a seller to a buyer of up to 6 percent of a property’s sales price.

5. Fifty-four percent of FHA’s 7.2 million loans are estimated to have a balance in excess of current property value.

6. As noted above, three-quarters of FHA home purchase loans in 2010 were high risk, having a down payment of less than 5 percent and/or a FICO credit score of less than 660, with many of these also having a total debt-to-income ratio greater than 45 percent. Thirty-eight percent of all of FHA’s new home purchase borrowers had excessive debt-to-income ratios (greater than 45 percent).

7. As of November 2011, more than 1 in 6 FHA borrowers were delinquent 30 days or more (a 17.42 percent delinquency rate).

8. Forty-two percent of government loans modified in 2010 (consisting primarily of FHA loans) had re-defaulted to a 60-day delinquency or greater after 12 months.

9. FHA, which provides 100 percent coverage against loss, currently loses 64 cents on every dollar of claim.

10. As of October 2011, FHA had 830,000 loans with current balances totaling $116 billion that were 60 days or more delinquent; a loan loss reserve sufficient to cover just these known 60+ day delinquent loans would likely exhaust FHA’s current cash reserves.

11. Even under a regulatory accounting scheme where projected future surpluses are counted as “economic value” today, FHA’s traditional single-family program has only $1.193 billion in economic value, resulting in a capital ratio of 0.12 percent, well below the statutory mandate of 2 percent. Thus, this program is leveraged at 842 to 1.

12. HUD acknowledges that a period of stagnant home prices would adversely affect the solvency of FHA’s mortgage insurance reserve fund. This underscores the fundamental flaw in FHA’s current business model: moderate home price inflation is required just to keep claims at an unacceptably high level of 7.5 per 100. This is no surprise, as a 3 percent down loan amortized over 30 years accumulates about 10 percent equity after 4 years. (N.B.: This was not always the case. When FHA started in 1934, homebuyers accumulated 30 percent equity in the first 4 years.)

Given these facts, the following steps should be taken immediately. Banking regulators should examine FHA to determine its current fiscal condition under generally accepted safety and soundness standards. Congress should recapitalize FHA to address any shortfall found in required loan loss reserves and its 2 percent capital requirement and use existing statutory authority to raise the annual premium to the maximum of 1.5 percent in order to rebuild capital to a minimum of 4 percent. FHA must end the practice of knowingly lending to people who cannot afford to repay their loans and must set loan terms that help homeowners establish meaningful equity in their homes. And it should concentrate on those homebuyers who truly need help purchasing their first home while stepping back from markets that can be served by the private sector.

Let’s not once again risk rolling snake eyes for the taxpayers.

Edward Pinto is a resident scholar at the American Enterprise Institute.